The stereotype of boring central banks has vanished

A good central bank used to be a boring central bank

Good central banking should be boring: this was the mantra for most central banks in the pre-crisis era. It was borne on the back of the “Great Consensus” in monetary policy among academics and practitioners in which the “one policy tool and one objective” framework —typically the policy rate and price stability respectively — formed the cornerstone of the modern day central bank. Added to the mix was the concept of independence: the notion that monetary policy should be free from political influence, but accountable to government, making it more credible.

… this all changed during the 'Great Panic'

However, this orthodoxy was shattered during the financial crisis as central banks rushed to develop innovative policy responses after interest rates approached the zero lower bound (see Figure 1). In the years after the ‘Great Panic’¹ of 2008 the world of central banking changed radically:

The Fed’s balance sheet ballooned from around $800 billion in 2007 to $4.4 trillion in August 2014 (see Figures 4 and 5) and its statement to markets has multiplied from about 250 words ten years ago to more than 800 today (see Figure 5);

The value of assets held by the Bank of England as part of its quantitative easing programme is now nearly equal to the combined assets managed by the country’s top 10 fund managers;

Switzerland’s central bank, the world’s 20th largest economy, is now the 4th biggest holder of foreign exchange reserves;

The European Central Bank (ECB), which is the monetary authority for 18 countries, has set negative deposit rates for the first time in its history (see Figure 1).

With great power, comes great scrutiny

One of the consequences of the financial crisis has been the disproportionate influence exerted by unelected central bankers. This has already caused elected government officials to challenge the democratic legitimacy of such a change:

In the US, for example, lawmakers are pushing for the introduction of a rule-based monetary policy which could limit the manoeuvrability of the Fed, particularly at times of crisis.

In other cases, the purchase of large amounts of sovereign debt by central banks has made governments nervous. It has also had some perverse consequences. For example, in 2012, the ECB made around €555 million in interest income from Greek Government Bonds (GGBs).

How can central banks safeguard their independence?

Lessons from history show that legal independence is not always enough; central banks also need to ‘earn’ their independence by demonstrating institutional capability. To analyse what makes a capable central bank in this new, more complex era of central banking, we’ve drawn lessons from the 60s, 70s and 80s, the period which earned central banks their independence to conduct monetary policy in the first place. Our review suggests that successful central banks demonstrated their capability in three key areas: leadership, analytical competence, and communication. The real test will come when central banks have to manage through conflicting economic and financial cycles, balancing monetary and macroprudential policy (see Figure 6) settings, and communicating this effectively. Let’s hope they are ready.